How to Persuade the I.R.S. and Treasury to Change Their Mindsroposed Schedule M-3: Giving the IRS a Roadmap to Questionable Transactions
(March 19, 2004)

How a recent change in the U.S. withholding tax rules came about is worth considering. While the change is one primarily of interest to financial institutions serving as Qualified Intermediaries (“QI”), the process by which the change came about may be of more general interest, since it illustrates advice that we have given on how to work with the I.R.S. and Treasury.

We were approached last fall by a group of international financial institutions concerned about the effect of the QI “small partnership and trust rule” in Rev. Proc. 2003-64, 2003-32 I.R.B. 306, published in August 2003. They were concerned particularly with a requirement that would require Form 1042-S reporting to the partners, beneficiaries or owners of their partnership and trust clients if that client received annually more than $200,000 in U.S. reportable amounts. Their national laws prohibit this reporting. The rule also would require all QIs to develop and implement expensive tracking systems to monitor the $200,000 limit and carry out any necessary Form 1042-S reporting if the limit were exceeded.

We knew that the U.S. would be reluctant to change a rule that it had recently issued without very good reason. We therefore first developed a detailed proposal with our clients that allowed the I.R.S. to remove the $200,000 limit, but also took full account of I.R.S. compliance concerns. Next we approached the I.R.S. and Treasury informally to determine if this proposal would be of any interest to them. Given the positive reaction, we submitted the proposal in writing to highlight how it would help both the I.R.S. and the QI community. We talked to the I.R.S. and Treasury throughout the process to answer their questions, and followed up with a further written submission to address their concerns.

We are happy to report that the I.R.S. and Treasury removed the $200,000 limit in Revenue Procedure 2004-21. For our QI clients, please note that all other limitations of the original small partnership and trust rule remain: (1) none of the partners, beneficiaries or owners may be U.S. persons; (2) the partnership/trust must be non-U.S. and a direct account holder of the QI; (3) none of the partners, beneficiaries or owners may be a passthrough partner, beneficiary or owner; (4) none of the trusts may be complex trusts; (5) the partnership or trust must agree in writing to make its records available to the QI external auditor; (6) the QI must treat payments to the partnership or trust as allocated solely to the partner, beneficiary or owner subject to the highest rate of withholding and must withhold at that rate; and (7) the collective QI refund procedures do not apply.

We stress that there are many situations where we have advised our clients that it would not be productive to ask the I.R.S. and Treasury to change a rule. When, however, a proposal allows both the private sector and the I.R.S. to achieve their mutual objectives, such an approach can be effective and should be considered.





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